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Navigating the Murky Waters of the Employee Retention Credit

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The IRS includes the ERC in its 2023 Dirty Dozen

On March 20, 2023, in IR-2023-49, the IRS kicked off its 2023 Dirty Dozen list of schemes and scams by issuing a very pointed warning to employers about improper claims for the ERC which, when properly claimed, may result in an eligible employer receiving a refundable tax credit of up to $26,000 per eligible employee. The IRS warning spotlighted, in very direct language, the “blatant attempts by promoters to con ineligible people to claim the credit” and restated that false claims promising tax savings that are too good to be true generate significant risk to employers. These third-party promoters often charge a percentage fee that is contingent on the amount of the refund. Also, many promoters do not make it clear to employers that they will need to amend their business’ federal income tax return for the corresponding period because any wages used in the computation of the credit are no longer deductible.

The IRS reminded employers that there are very specific guidelines that address eligibility for this credit and admonished that, contrary to what some promoters are saying in advertising and unsolicited phone calls and emails, the ERC is not available to just anyone. And because employers are always responsible for the accuracy of the information reported on their tax returns, the IRS emphasized that improperly claiming the ERC could result in employers having to repay not only the credit, but also penalties and interest.

Including improper ERC claims on the 2023 Dirty Dozen came as no surprise to those who have been following the IRS’s ERC-related announcements closely. On March 7, 2023, the IRS issued IR-2023-40 to renew its October 19, 2022 warning (IR-2022-183) about third parties aggressively promoting false ERC claims on radio and online, and in many circumstances, misleading employers about eligibility for the ERC and its complexities. Unusual is both the fact that the IRS is warning in very strong terms about a tax credit of relative broad applicability to business taxpayers (as opposed to individual taxpayers), and that many of the perceived abuses arise from advice provided by established specialty tax consulting firms working under similar contingent fee arrangements to those used by newly-created “credit mills.”[2]

In its Dirty Dozen announcement, the IRS advised that—unlike tax professionals who are carefully and competently advising clients on the complexities of the ERC—“third party promoters of the ERC often don’t accurately explain eligibility for and computation of the credit” and the promoters “may make broad arguments suggesting that all employers are eligible without evaluating an employer’s individual circumstances.” We described some of our concerns about how the ERC should be approached in November 2022. The IRS encouraged the tax professional community to continue to advise clients not to file ERC claims when the tax professional does not believe that the employer has an appropriate basis for filing such claim.

Now what? How to tell if an ERC claim may be improper

When approached with diligent attention to its rules, the ERC provides a benefit to certain employers whose business operations were negatively impacted by the COVID-19 pandemic. However, there is also a spectrum of dubious ERC advice and eligibility determinations being provided by some promoters (or advisors).[3] This spectrum of advice ranges from flat-out “cons, schemes and scams” (all words used by the IRS) which take minimal account of IRS guidance, to extreme interpretations of the ERC guidelines by more technically savvy tax practitioners. All of which the IRS may challenge if the claims are audited. As a starting point, apart from situations where an employer qualifies for the ERC because of a decline in gross receipts, we believe the critical prerequisite for ERC eligibility requires the employer to be able to determine how a governmental order caused a full or partial suspension of trade or business operations. These rules are provided in Notice 2021-20.[4] However, Notice 2021-20 for the most part does not articulate simple bright-line standards and leaves significant room for interpretation as to whether a governmental order caused a “full or partial suspension of business operations.”[5] Thus, there is no “one size fits all” test that enables a business employer to readily assess whether their ERC claim may fall within the range of abuses the IRS is warning about. Nonetheless, here are some of the questions we believe employers should ask as they consider the strength of their ERC claims:

1. How much time did the advisor spend talking to the employer about the facts and circumstances of the employer’s business operations? Except in instances where the employer is eligible because of the decline in gross receipts, we would expect there to be an actual interview to understand how the employer’s business operated before the pandemic and then during each quarter of the pandemic (particularly in each of the first three quarters of 2021 where the wage limits are applied on a quarterly basis). We believe that this interview process should be more than a “quick” phone call.

2. Based on the interview and other information gathered, did the advisor prepare a written narrative that both identified the specific state or local governmental orders the business was subject to and described their impact on the employer’s business operations? As a general matter, we would expect this written narrative to be comprehensive enough to explain to an IRS examiner what provisions in the governmental order applied to the employer’s business operations and how these provisions caused the business operations to be suspended in whole or part.[6] In this regard, we believe that the ensuing narrative should describe with specificity the fundamental changes the employer had to make to operations at the core of its business. In contrast, we would be concerned when the written narrative looks like a “cookie cutter” analysis and does not describe and analyze the employer’s actual business operations in a particularized manner.

This written narrative should also discuss when these modifications ended as governmental orders (and actual behavior) evolved during 2020 and 2021. We would also expect the advisor to share a draft of this written narrative with the client in order for the client to review its factual accuracy. Obviously, the final copy of the written narrative (as well as other supporting documents) should be provided to the client so it is readily available for review by their auditors or the IRS.

3. Has the advisor reviewed with the employer any situations where the IRS guidance regarding ERC eligibility is not reasonably clear and where the advisor’s interpretation of the IRS guidance may be construed as aggressive? As a starting point, applying a new federal tax law to many varying fact patterns often involves more art than science. What seems a reasonable position from a taxpayer’s perspective may be an aggressive position from the IRS perspective.[7]

We believe the IRS is concerned that in making eligibility determinations, many advisors are not paying sufficient attention to the need for a tight causal relationship between the mandates set forth in government orders and the changes in business practices during the COVID-19 pandemic that employers took (even when not specifically compelled to do so by a binding governmental order).[8] Further, we believe that many advisors are making ERC eligibility determinations by selectively reading specific language in the ERC guidance without taking into account its context and connection with other relevant– and arguably interconnected– rules.

To illustrate our concern, here is one example of what we believe is a very aggressive interpretation of the rules. More specifically, some promoters are concluding that changes made to business operations because of guidance issued by the Occupational Health & Safety Administration (OSHA) and the Centers for Disease Control (CDC) is on its own sufficient to constitute a partial suspension pursuant to a governmental order. While we will elaborate on our concerns with this interpretation in a subsequent Buzz, for present purposes, we point out that in written analysis describing this position we have seen, the promoter has reached an ERC eligibility determination based on OSHA/CDC guidance without even discussing the relevant provisions in Notice 2021-20 or referencing the applicability or non-applicability of any more specific state or local governmental orders.

In a forthcoming Buzz, we will provide other examples of fact patterns where we believe many promoters are either not adhering to the ERC guidelines at all, or where they are interpreting the guidelines in a similarly aggressive manner. Our point in raising this is not to say that aggressive interpretative positions should never be taken. Rather, where an eligibility determination relies on a non-straightforward interpretation of the IRS guidance, we believe the client should be aware of this and make an informed decision. This conversation is easier said than done but we recommend that clients specifically ask their ERC advisors to point out any areas where ERC eligibility was not clear cut and was not based on clear guidance in Notice 2021-20.

A client should not be under the impression that an ERC claim is strong when in reality the claim is based on an interpretation that may be subject to close scrutiny by the IRS and could give rise to a contentious audit. Obviously, if the client loses on audit, the client will ultimately be responsible for repaying the tax amount plus penalties and interest.

4. Is the promoter claiming that an ERC claim needs to be filed before “funds run out”? Contrary to what employers are told in some radio, tv and internet advertising, there is no “pot of money” that will be exhausted if an employer is slow to file an ERC claim. For ERC claims in the eligible quarters in 2020, an employer has until April 15, 2024 to file a Form 941-X for those quarters. For ERC claims for the eligible quarters in 2021, an employer has until April 15, 2025 to file a Form 941-X. An employer should be very cautious of a promoter who conveys a false sense of urgency to file an ERC claim.

5. Did the promoter inform you that qualified wages used in ERC computations are no longer deductible on your business income tax return? This is a fundamental requirement incident to receiving the ERC. Even though the promoter will not itself be dealing with the employer’s business income tax return, if the promoter did not advise the client of this related critical requirement, we would question the promoter’s overall competence.

6. Does the promoter claim a high IRS audit success rate? The IRS is just starting its ERC audit program. Because the audit program is in its infancy, any audit success percentages cited in promotional materials to date are meaningless. As a result, we believe employers should be wary of promoters that use terms such as “audit proof,” “guaranteed” or “certified” to describe the ERC claims they prepare. Reputable tax advisors ordinarily do not use these terms. Instead of using feel-good language, tax professionals speak in terms of an estimated likelihood of success if a tax position is challenged by the IRS.

7. How long has the promoter and its leadership been in the tax advisory business? Although this consideration may not be dispositive—tax professionals do change business models or start up new firms—a promoter’s decision to start a practice that focuses exclusively on the ERC raises a yellow flag that calls for employer diligence to make sure the promoter has sufficient experience and competence to advise on the technical and computational nuances of the employer’s ERC claim.[9] Also, the employer should consider whether a more established and diverse tax advisory firm practice will be better situated to provide audit defense and/or stand behind any commitments in the engagement letter to refund fees if all or part of the ERC claim does not survive an IRS audit.

8. Is the promoter advising that you are eligible for the ERC contrary to the advice of your long-time CPA? It is not uncommon for different tax professionals to reach different conclusions about how a complicated or novel area of tax law should be interpreted. Nonetheless, if the promoter is dismissive of the CPA’s views, this is a “data point” that, again, raises a yellow flag.[10] Anecdotally, we are aware of many situations where promoters have told employers that their CPA’s do not know enough about the ERC in order to determine eligibility. An employer should endeavor to understand why their CPA is reaching a more conservative position. A reputable CPA will readily inform a client when they do not believe they have the appropriate experience to advise on a tax matter and in most instances will refer the client to another competent practitioner.

Promoters advising on “one-off” tax positions, especially where they are being paid a contingent fee, have an incentive to take a more aggressive position when interpreting IRS guidance because obtaining a higher refund for the employer increases their own fee. In particular, we recommend that extreme caution be exercised if the “fine print” in the promoter’s engagement letter (i.e., written fee agreement) contains disclaimer language to the effect the promoter is not providing tax advice or acting as a tax preparer. Regardless of any such disclaimer, a Form 941-X is still a tax return, and someone recommending a tax refund claim is still giving tax advice. Clients should be wary of advisors that purport to be experts in ERC but then in their engagement letters state that they do not provide tax advice.

If I already filed my ERC claim, what should I do if I have concerns?

Obviously, the above questions are not determinative of whether an ERC refund claim is “legitimate” or “abusive.” But if answers to these questions raise yellow flags, we recommend that the employer consult an independent tax advisor to review the merits of their ERC claim and the sufficiency of their documentation. To the extent that an independent review concludes that the previously filed Form 941-X’s should be amended (or withdrawn), the employer may be able to avoid interest and penalties as well as the uncertainty, time, expense and stress of an IRS audit. On the other hand, if an independent review results in written advice concluding that the employer’s ERC claim is supported based on the facts and applicable tax law, such independent review should enhance the employer’s ability to show that it exercised reasonable cause and good faith. As a result, even if the IRS subsequently disallows all or part of the claimed ERC credit, the employer would be able to raise meritorious defenses to a penalty’s assertion, particularly before the IRS Independent Office of Appeals.

Finally, to put all of this in perspective, our point in raising the concerns above is not to scare employers from taking the ERC when appropriate, but rather to point out our best guesses of warning signals that may foretell murky waters. As tax lawyers, we regularly deal with gray areas and readily advocate for a favorable outcome even in the face of ambiguous tax law. However, while we always endeavor to find alternative approaches to support a desired tax position, as trusted advisors, we do our clients no service when we do not inform them of inherent uncertainties. We always urge our clients that even if some discomfort results, most tax problems — real or perceived — can be minimized by early and thoughtful consideration.

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For questions about what steps should be taken to review the sufficiency of an ERC claim or how to prepare or respond to an IRS employee retention credit audit, please contact H.T. Astrov or one of the other tax professionals at Zaino Hall & Farrin LLC.

[1] Sometimes this is also referred to as Employee Retention Tax Credit (ERTC).

[2] It is noteworthy that often these specialty tax consulting firms are structured so that they are not bound by restrictions against charging contingent fees contained in both Treasury Department Circular No. 230 (Regulations Governing Practice before the Internal Revenue Service) and the AICPA Code of Professional Conduct.

[3] These terms are used interchangeably. No inference is intended because of the word choice.

[4] 2021-11 I.R.B. 922. Other parts of Notice 2021-20 (besides definition of Governmental Orders and Full or Partial Suspension of Business Operations) were amplified by Notice 2021-23, 2021-16 I.R.B. 1113, Notice 2021-49, 2021-34 I.R.B. 16 and Rev. Proc. 2021-34 I.R.B. 34.

[5] Part of the problem is that Notice 2021-20 was released in March 2021. Given the range of positions about ERC eligibility, we believe both the IRS and employers would be well served if the IRS issued more specific updated guidance on these aspects of the rules (Part C- Governmental Orders and Part D- Full or Partial Suspension of Business Operations) to address additional fact patterns concerning to the IRS and interpretive ambiguities that the tax professional community has pointed out. Additional guidance on an expanded array of fact patterns would benefit employers who don’t want to forgo a meaningful tax credit that they are arguably eligible to receive but who also want to act responsibly.

[6] In some narrow situations, if a governmental order shuts down a critical supplier to the employer and as a result the employer has to suspend operations, then the governmental order binding on the supplier is attributed to the employer. See Notice 2021-20, Q&A 12.

[7] As long as a “return position” (i.e., how a taxpayer reports a deduction, credit, or exclusion on a tax return) has at least a “reasonable basis” (and a Form 8275 Disclosure Statement is included with the tax return), it is not improper for an item to be included on a tax return.

[8] See, Notice 2021-20, Q&A 11, which provides that for employers operating any “essential business” (i.e., a business not completely shut down under a governmental order), “a partial suspension of operations [results only] if, under the facts and circumstances, more than a nominal portion of its business operations are suspended by a governmental order.” This is the first of 12 separate Q&A’s in this section of Notice 2021-20. To illustrate the complexity, this section on full or partial suspensions also contains 14 examples.

[9] We are also aware of payroll service providers making ERC determinations for their clients. Although payroll service providers are very familiar with the Form 941, because of the many qualitative aspects involved in determining ERC eligibility, we recommend exercising similar diligence to make sure that the payroll service provider has the necessary competence to advise on ERC eligibility.

[10] Adopting the recommendations of a financially motivated promoter and disregarding the guidance of the CPA would also be a significant factor in whether the client may be able to claim that it had reasonable cause and acted in good faith for purposes of defending against a negligence or civil fraud penalty.

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